IRC 2036(a)(2): Mixed Messages from the Tax Court?

Take-Away: Previously we covered the surprising Tax Court decision in Powell which applied IRC 2036(a) (2) to include in a decedent’s taxable estate the value of limited partnership interests because the decedent, as a limited partner, could vote with the general partner(s) to liquidate the limited partnership, thus retaining some level of control over the enjoyment of income from the partnership assets. That decision raised the specter of the IRS using IRC 2036(a) (2) as its new ‘weapon’ to cause estate tax exposure for family controlled entities. However, after Powell, the Tax Court had another occasion where IRC 2036 (a) (2) could have been applied, yet it made no mention of that Tax Code string provision. Some direction would be helpful in this period of large lifetime gifts where donors are encouraged to use their temporarily enlarged federal gift and GST tax exemptions to make substantial gifts.

Background: The Tax Code has three separate string provisions that are used to drag back into an individual’s taxable estate the value of assets that they transferred during their lifetime. [IRC 2036- to 2038.] One provision that often has been overlooked, at least before Powell, was IRC 2036(a) (2). That provision includes the value of transferred property in a decedent’s taxable estate, if after that transfer, except for a bona fide sale for an adequate and full consideration, the decedent retained the possession or enjoyment of, or the right to the income from, the transferred property [IRC 2036(a)(1)] or the right, either alone or in conjunction with any person to designate the persons who shall possess or enjoy the property or the income therefrom.[IRC 2036(a)(2).]

Powell v. Commissioner, 148 T.C. No. 18 (May 18, 2017):  The Tax Court’s willingness to apply liberally the in conjunction with condition was the big surprise of Powell. In that case, the mother transferred (just days before her death) $10 million to a family limited partnership. She took back 99% limited partnership interests, while her sons made nominal contributions and took back the 1% general partnership interest. The mother then transferred her 99% limited partnership interests to a charitable lead annuity trust (CLAT), resulting her estate’s claim that she owned no part of the limited partnership that she created and funded.

• Authority to Dissolve: The limited partnership agreement provided that the partnership could be dissolved by an agreement of all the partners. Therefore, while the mother, as the limited partner, could not unilaterally dissolve the partnership and retrieve her contributed capital, she could vote in conjunction with the general partners to dissolve the limited partnership.
• Durable Power of Attorney: Several other ‘bad facts’ also contributed to the Tax Court’s decision in Powell. For example, the transfer of the mother’s 99% limited partnership interests to the CLAT was determined to be invalid. The transfer had been made by the son using his mother’s durable power of attorney. However, that durable power of attorney did not authorize the agent to make any charitable gifts. Consequently, that charitable gift was voidable. Even if the transfer to the CLAT had not been voidable,  the value of that charitable gift would nevertheless be brought back into the mother’s taxable estate under IRC 2035 since it was a transfer within 3 years of her death.
• In Conjunction With: With regard to the in conjunction with trap of IRC 2036 (a)(2), the Tax Court found that the mother’s power, with her sons as the general partners, to (i) terminate the limited partnership, (ii) along with her durable power of attorney agent’s authority (as a general partner) to determine partnership distributions, each constituted a retained right to determine possession or enjoyment of the transferred property under IRC 2036 (a)(2). In sum, the Tax Court held that because the mother could join together with her sons to dissolve the limited partnership, or to determine the amount and timing of partnership distributions (as the son-general partner had fiduciary duties to his mother), it was appropriate to include in the mother’s gross estate the value of the property that she transferred to the limited partnership in exchange for her limited partnership units.

Estate of Streightoff v. Commissioner, T.C. Memo, 2018-178 (October 24, 2018):  In this case Frank formed a family limited partnership with several of his family members. Frank received in exchange an 89% limited partnership interest, which he immediately titled in the name of his revocable trust. In this case,  the limited partnership agreement gave Frank, the limited partner, the right if he owned more than 75% of the limited partnership interests, to (i) approve the admission of other limited partners; (ii) remove a general partner, which would terminate the partnership; (iii) to reconstitute the partnership if the general partner was removed; and (iv) to elect a new general partner. In short, Frank retained control over the general partner, even though he was a limited partner, so long as Frank owned at least 75 % of the limited partnership interests.

• Assignee Interest: Frank’s estate came up with a clever valuation argument on his death. It claimed that Frank only owned an assignee’s interest in the limited partnership at the time of his death, since his limited partnership interests had been assigned to Frank’s revocable trust prior to his death. Accordingly, what should be valued on Frank’s death was an assignee’s interest, not an 89% limited partnership interest. As such, Frank’s estate claimed a 13.4% lack of control discount and a 27.5% lack of marketability valuation discount on the assignee’s interest.
• IRS: The IRS responded that Frank owned an 89% limited partnership interest, resulting in no valuation discount for a lack of control (Frank still had control under the limited partnership agreement over the general partner) and only an 18% valuation discount for because Frank’s limited partnership interest lacked marketability. The Tax Court noted that up until the moment of his death, Frank could have revoked his trust and thus that would have caused the 89% limited partnership interest to be included in his taxable estate- so much for the estate’s assignee’s interest Therefore, there was no valuation discount available for any lack of control of Frank’s 89% limited partnership interest.
• Value Included In Frank’s Estate: What the Tax Court ultimately valued was Frank’s 89% limited partnership interest (with discount), not all of the undiscounted assets owned by the limited partnership which had been the result in Consequently, this was a partial victory for Frank’s estate.
• Retained Control: What was surprising with the Streightoff decision was that there was no mention by the Tax Court of either Powell or IRC 2036 (a) (2). Clearly Frank, as a limited partner who owned more than 75% of the limited partnership interests, could remove the general partner who, in turn, had control over partnership distributions, so that indirectly Frank acting alone, and not necessarily in conjunction with others, could have controlled the income or enjoyment of the limited partnership triggering the application of IRC 2036 (a) (2).

Conclusion: The Powell decision has drawn a lot of attention and numerous scholarly articles warning of the dangers of its liberal interpretation of in conjunction with.

• Some of those suggestions include sanitizing limited partnership agreements and LLC operating agreements to eliminate any indirect control retained by the transferor of assets to the FLP or LLC.
• Other suggestions have gone even further and radically suggested that parents who created and funded the FLP or LLC re-write their durable powers of attorney to eliminate naming their child as their agent when that same child holds a general partnership or managerial position of an LLC, where control over entity distributions could be imputed to the agent’s principal under the durable power of attorney.
• Finally, other articles have encouraged senior family members who created FLPs and FLLCs to take advantage of their enhanced, albeit temporary, gift and GST exemptions and transfer retained limited partnership or LLC interests so that nothing has been retained by the time of their death.

The lingering question is whether Streightoff is an anomaly in light of Powell, or is the Tax Court  not inclined after all to use Powell’s liberal interpretation of in conjunction with as the standard to measure all future estates that hold family limited partnership interests. Only time will tell.